What is it?
Enterprise value (EV) is an alternative to computing the value of a company based on market capitalization of its equity, total debt and cash. It is considered a more comprehensive tool to analyse the value of a company compared with simple market capitalization of equity shares. An easier way to understand this concept is to consider it as the total sale price or takeover price of an entity. So, if a company was to be bought out, this is the price to be paid.
How is it calculated?
EV is calculated by adding market capitalization of equity shares (common and preference) to the market value of debt and minority interest (investment in another company). From this, the total cash and cash equivalents are taken out to arrive at the EV. This is considered a more accurate representation of a company’s value as it considers debt in the overall valuation.
How is this used?
EV is seen in combination with other financial parameters to compare potential stock price returns among different companies. EV/Ebitda (earnings before interest, tax, depreciation and amortization) is a commonly used ratio for analysing the value of a company. A low ratio can signify that a company is undervalued. This ratio is also called the enterprise multiple.
Enterprise multiple comparison works best within an industry as it can vary across sectors. It is thus, important to compare this for companies within an industry. Multiples will be higher for industries where growth is high and lower for slow-growth industries. For example, if analysts had estimated telecom company ABC’s EV/Ebitda for FY11 at 7.5, whereas that for telecom company XYZ at 8.5; one can conclude that ABC is relatively undervalued compared with XYZ and hence, the probability of ABC’s stock value increasing is higher.
There are other metrics that analysts use—EV/sales and EV/tonne (for manufacturing companies such as cement), which also help in understanding whether the market is valuing the company fairly or not.
What does it mean for you?
From the industry’s perspective, an undervalued company makes for a good takeover candidate. From an investor’s perspective, an undervalued company means better opportunity for rise in stock price. An overvalued company may indicate an exit if other fundamental factors also indicate the same.
Keep in mind that financial parameters such as EV and EV/Ebitda should not be looked at in isolation. Remember to consider other financial parameters and fundamental characteristics.
Ensure that you compare with a historical perspective and across companies in an industry.